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One way to address valuation issues and mitigate investor risk is to use the
conversion ratios that we discussed earlier. One method is through the con-
version feature of the preferred stock. Commonly, preferred stock will ini-
tially convert on a one-to-one basis at the time it is issued. In the event of
antidilution protection on a down round, the conversion ratio will automat-
ically adjust so that each share of preferred stock will convert into more than
one share of common stock. This mechanism offsets the lower-priced is-
suance by increasing the preferred holder™s ownership percentage in the
The same mechanism can be used to address a valuation issue. Suppose
an entrepreneur believes his company should be valued at $10 million while
an investor thinks it is worth only $7 million. With a $1 million investment
at a $10 million premoney valuation, the investor would end up owning 9.1
percent of the company; at a $7 million premoney valuation, the investor
would own 12.5 percent of the company. The investor states that he or she
would agree to the $10 million valuation if the company were able to recruit
a certain CEO within three months.
For example, the entrepreneur could sell the investor a 12.5 percent stake
on a postinvestment basis but provide that the conversion ratio of the pre-
ferred stock be adjusted to result in a lower number of common share equiv-
alents if the CEO joins within the specified time frame. Variations such as this
one abound. The conversion ratio might have three different possible settling
points based on the reaching of various milestones. Or the ratio might not be
set at all until some future point when milestones can be measured.
Another way to resolve a valuation disagreement is to provide for mul-
tiple closings of the investment. An investor may be willing to risk a portion
of the amount requested of him up front, but may be unwilling to put in the
whole amount at the proposed valuation.

For example, the investment agreement could provide for an initial clos-
ing of 50 percent of the total amount to be invested. The agreement could
then provide for an additional closing of the remaining 50 percent to occur
before a specified date, based on the company™s achievements of milestones.
These milestones would be negotiated between the parties and would consti-
tute the thresholds that the investor feels are required to merit each remain-
ing portion of the investment.
Depending on the stage of the company, the milestones might relate to
stages of product development, the hiring of a CEO, the issuance of a patent
or copyright, new customer contracts, revenue levels, or, for more developed
companies, levels of operating income. In Internet companies, milestones
often relate to the beta stage of a web site, a targeted number of subscribers
to a service, or a deal with a portal company or other strategic partner.
Critical to this multiple closings strategy, of course, are the understand-
able, simple milestones that people can agree on. Fuzzy milestones (e.g., per-
haps different interpretations of a cash flow formula) later become serious
hindrances to the company™s progress. In structuring a deal in this way, the
entrepreneur is declaring that if he or she fails to perform, the investor has
the option”but not the obligation”to put in further money, perhaps nego-
tiating a lower valuation.


In early-stage companies, as we have said, value lies in the future. Such un-
certainty renders less useful the established valuation formulae, which de-
pend on more precise data and calculations. Valuation expert John Cadle
offers instead an expanded real-world definition of value for the early-stage
private business: “That point at which an investor™s fear (risk profile) is in
equilibrium with his greed (return requirements).” Ultimately this is accom-
plished by coming up with an agreed on percentage ownership between the
investor and the entrepreneur.
In the real world, then, an equity ownership position should produce an
expected annualized rate of return over a reasonable time proportional to the
investor™s tolerance for risk. Valuation in this context does not depend on
hard assets, prior sweat equity, intellectual property, book value, asset re-
placement, or similar items. These considerations enter into the equation
only to the extent that they can generate future value or for comparative pur-
poses. Valuation depends on the creation or expansion of a going concern
into a marketable commodity through an event that provides liquidity for
the investor, such as by acquisition or IPO. Valuation also depends on the
amount of risk that has already been mitigated by the company in product
Valuation of the Early-Stage Company

development, marketing, customer franchise, and cohesion of the manage-
ment team.


Valuations and multiples or ratios in the public stock market, supply of cap-
ital and level of capital demand, current and projected interest rates set by
the Federal Reserve are all examples of macroeconomic factors that might
determine an investor™s valuation. Meanwhile, more subjective determinants,
that is, individual investor requirements, can significantly influence the valu-
ation calculation, a calculation that might include the risk profile of the in-
vestor, the risk associated with various company characteristics (e.g., stage
of development, management experience, and time to liquidity), the level of
investor involvement, and the dilution.
For current or potential angel investors, a number of macroeconomic de-
terminants can influence their valuation of a company. The following check-
list may help in weighing some of those factors:

– The stock market. While the stock market obviously determines the
value of a publicly held company, it also affects privately held compa-
nies. The higher and more buoyant the stock market, especially IPOs,
the greater the impact on early-stage company valuations. Internet com-
panies serve as prime examples. The problem in the late 1990s was the
absolute explosion in IPOs, primarily Internet companies. That explo-
sion was compounded by the compression of time. In the late 1980s and
early 1990s, the standard waiting period from seed stage to either an ac-
quisition or an IPO was three to five years, usually closer to five than to
three. In the case of Internet companies, market watchers in the late
1990s viewed one or two years as a long time.
Today presents a different set of circumstances. The tech stock melt-
down, the dot-com bust, and the moribund stock market all conspired
to reduce valuations. While many public stocks are still considered over-
valued, the impact on the private equity market is more insidious.
Without access to the IPO market, a huge overhang of venture-backed
early-stage and first-stage companies (estimated at 7,000 companies)
await liquidity events. This backlog could take years to provide exit, un-
less they are written off. The primary impact has been downward pres-
sure on early-stage, private company valuations in private placement
– Money supply and capital demand. The money supply for early-stage
companies has suffered contraction. Many venture capital firms are hus-

banding capital to finance portfolio companies, more developed investee
companies that may be unable to raise capital or find an exit. It is esti-
mated that as many as 50 percent of early-stage venture capital funds
may no longer exist in five years. Corporate and institutional investors
have all but disappeared from the early-stage market. And angels who
suffered losses in both their public and private portfolios to the tune of
trillions are investing less often and making smaller investments. Most
important, increased caution is manifest in longer due diligence cycles
and increasing negotiation pressure on valuation and deal terms, caus-
ing increased expense, longer time frames to raise capital, and increased
equity distributions to investors. All this is happening as entrepreneurs
find themselves competing with more and more developed companies
for a smaller pot of gold.
– Interest rates. By June 2004, the Federal Reserve had lowered interest
rates a dozen times to their lowest level in 20 years. Interest rates at the
time of publication are showing signs of upward pressure with slight
trends in inflation. However, the Fed had kept rates at historic lows for
two years and the rates appear relatively stable. A lower interest rate the-
oretically will lower the “hurdle” rate for equity returns in general, and
the returns for venture capitalists and angel investors in particular. When
interest rates go down”that is, when the risk-free rate decreases”in-
vestors anticipated lower rates of return for the use of their capital; the
result is that valuations on early-stage deals have stabilized at the lows
attained in 2002 and 2003, and, in fact, have shown some improvement.
In effect, valuations of private companies are inversely correlated to in-
terest rate trends on investment instruments such as Treasury bonds.
When an investor can only earn a few percent on lower-risk or risk-free
investments, not even keeping up with inflation, there is a pressure to in-
vest a portion of discretionary net worth/capital into higher-risk/high-re-
turn private deals. And entrepreneurs are now starting to see angels
reenter this market.

Different types of investors have different risk profiles. Things will be differ-
ent among private investors, newly affluent investors just entering the
market, and professional investors. And things will also be different within
each group. Moreover, these risk profiles are often hardwired, or tough to
Angel investors™ orientation to risk is not monolithic. So valuation of the
same venture can vary significantly depending on which individual investor
Valuation of the Early-Stage Company

is evaluating the deal. If he is an institutional venture capital investor with a
billion-dollar portfolio and he is investing $l million in a company, he is
probably willing to take more of a valuation risk. If he is an angel investor,
and this investment is one of only three, and he is investing 50 percent of his
available capital in the deal, this calculation will be affected by the investor™s
risk profile”and thus have an impact on the valuation.
The only way to mollify the investor™s perception of risk is to work on
the subjective factors that will make him feel more comfortable with the
deal. In other words, as the entrepreneur, you must convince the investor that
you are the world™s greatest manager, convince him of the vision, sell the
dream. Rather than sell investors on the subjective elements of the venture,
some entrepreneurs mistakenly try to convince investors that they don™t un-
derstand their own risk profiles.

Stage of development, experience of management, time to liquidity, and pro-
jected return multiples are just a few of the elements at the company level
that can have an impact on valuation. For example, early-stage companies,
unproven management, longer time to liquidity, and returns not significantly
above those available in the public market will all serve to reduce an in-
vestor™s valuation of a venture.
The stage of a company™s development is a measure of investment risk
and is an important aspect in valuing a company. In fact, the stage of devel-
opment may be more important in describing the risk than the current round
of the investment. The success of investments in start-up companies is sub-
ject to the whims of the capital markets, because these companies have to
raise money frequently, and if market conditions are unfavorable, severe di-
lution can result. On the other hand, later-stage companies are subject to the
whims of the new issue window.
Potential risks and rewards vary substantially during the different stages
of development in a new venture. Despite every entrepreneur™s confidence in
this “sure thing,” more new ventures fail than succeed. However, investors
need only a few big winners to offset the losers. Depending on the risks in-
volved, compound rates of return from 25 percent to 50 percent per year or
more constitute targeted expectations. There is a direct relationship between
stage of development, as defined earlier, and market value, as calculated by
the angel investor. This gets translated into variation in expected rates of re-
turn”for example, 60 to 100 percent rates of return for seed or start-up
companies, and 20 percent rates of return for bridge or mezzanine financings.
The pricing curve shown below (Exhibit 13.1) captures this relationship

Value E
N 5th

1st Round

Stage Start-up Development Revenue Profitable Public


Figure 13.1 Venture Price Curve

and to some extent explains the angel™s penchant for earlier-stage deals. If the
angel investor gets into the deal on a start-up basis, he or she will pay a lower
price (lower valuation) and correspondingly take on a lot of risk, but with
the potential for higher returns to compensate that risk. Development- and
revenue-stage companies have many of the same risks as a start-up; that is,
the investor does not know if the companies possess all of the ingredients
necessary for success. Yet, as the chart illustrates, the valuations are signifi-
cantly higher than the start-up, with less potential for high returns because
of higher valuation.
The reason for this perhaps is clearer in the stylized graph (Exhibit
13.2). The stage of development”start-up, development, revenue, prof-
itable, or public”has a direct correlation with market value. Consequently,
the targeted rates of return of early-stage, private equity investors will corre-
spond”for example, 60 percent to 100 percent for seed or start-up, versus
20 percent for a bridge to cash out.
Using projected revenues, profits, and growth rates, entrepreneurs and
investors should arrive at a shared vision of the venture™s value for the three
to five years that follow financing. A business plan built on realistic assump-
tions is an entrepreneur™s best friend at this point in the pricing process and
negotiation. At least four basic principles are involved in arriving at a pric-
ing decision: (1) the division of equity determined by future value and equity
required to compensate investors at competitive rates; (2) the greater the ex-
pected worth of the venture at some future time, the lower the share of eq-
uity required to purchase any given amount of capital; (3) the longer the
track record of a new venture, the lower the investment risk, and therefore
the lower the share of equity required to purchase any given amount of cap-
Valuation of the Early-Stage Company


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